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In the second part of a series of articles on startups, we explore in detail the concept and essentials of co-founder agreements. For a couple (or group) of entrepreneurs starting up, the post-brainstorming plan when getting a business off the ground will mostly involve the nitty gritties of getting your product, service, team, office, marketing and such going. In the heat of the moment though, a crucial part of your young business, and indeed something that may have long lasting repercussions, is often overlooked.
A co-founders agreement, which is a more nascent form of a shareholders agreement in a company, is a binding document between the founders of a company that sets out their relationship, stake, responsibilities, liabilities, exit strategies and so on. While back-of-a-napkin agreements or terms agreed to over a beer and a handshake may be where your business partnership takes off, the lack of a detailed written and agreed to document can cause a lot of heartburn should things ever go south. The complexity of the document itself depends on the terms agreed between the co-founders and the structure of the business. However, there are some essential elements all co-founder agreements must contain. These are:
1. Equity ratio and capital contribution: While there is no minimum prescribed share capital required to be brought into on incorporation (under the new company law), as the company's first shareholders, the co-founders will make capital contributions into the company, and correspondingly be issued shares in proportion to their contribution. It is also likely that this contribution will be in equal parts. Whatever the ratio, the equity contribution and future contributions, if already envisaged, should be captured upfront in the co-founders agreement. A skewed equity ratio, unless there is a cogent and agreed to reason, may lead to disagreements between co-founders. Additionally, to make sure that a co-founder does not leave the company out of turn or in violation of the objectives of the company, his shares can be 'locked in' for a certain amount of time. The co-founder will not be able to sell his shares in the company till such lock-in ends.
2. Roles and responsibilities within the organisation: Most co-founders at a startup will (or should) have clearly defined roles and responsibilities within the organisation, playing on their respective strengths and keeping in mind the objectives of the business. This understanding of who will be involved in what part of management and operations of the company should be set out in the co-founder agreement so as to avoid any overstepping of roles and responsibilities. As the company evolves, these can of course, be amended.
3. Remuneration and benefits: The remuneration the co-founders draw from the company can be a contentious issue if any disagreements over the company spring up between them. In young companies that are bootstrapped or have seed or angel funding, money is scarce and hence any amounts being drawn by its co-founders as salaries should be pre-agreed. Remuneration should also be linked to performance, roles and responsibilities, rather than just shareholding. An easy way out is to agree that remuneration will be minimal -- this allows the company to preserve its cash balance.
4. Dilution and exits from the company: As a startup, it is likely that once you are off the ground, you may look for outside investment in the form of seed or angel investment. In such cases, co-founders, who hold all the equity in the company going in, will need to dilute their shareholding in favour of incoming investors as the company issues new shares in exchange for a capital infusion. The ratio in which the co-founders shares dilute in cases of a capital infusion should ideally be identical, but a co-founder agreement could provide alternative mechanics for how this should be calculated as and when the company seeks investment. Be careful of what you draft into your document here and/or what you agree to here - remember Eduardo Saverin? At a later stage, in a private equity investment round, for example, it will be more common for co-founders to sell their shares directly to the investor, rather than the company issuing new shares or a combination of a dilution through issue of new shares and sale of existing shares at an agreed valuation.
The sale of shares of a co-founder also becomes relevant when a co-founder, for any reason, has to exit the company. This could be in line with a co-founder's pre-determined objective or due to differences with the other co-founders. While the best time for a co-founder to sell his shares will be at the time of an investment in the company, the timings of an exit and an investment are unlikely to correspond, and the company may not want to string along a co-founder till an investment round and reap the benefits of a valuation he did not contribute to. In such a case, the co-founder agreement can provide for several options. These could be in the nature of sale of the shares of the co-founder at a pre-determined price to the existing investors (including co-founders). The co-founder agreement should also provide the remaining co-founders, in case of a contemplated exit, a right of first refusal over the shares.
5. Intellectual property rights: A lot of what a startup company has as assets, particularly in cases of tech start-ups, is its intellectual property. This could range from a domain name, to app and website design, codes, copyrights, trademarks, and in some cases patented or patentable information. While at the outset the intellectual property of the company, where registerable (such as trademarks, domain names and patents) may be in the name of its co-founders, the objective should be for these to be in the name of the company. All other intellectual property such as codes or content developed by the company should also expressly be agreed by the co-founders to be in the company's name. This allows for the intellectual property intrinsic to the company to be held by it in its name, independent of its co-founders who may or may not stay with the company in the long-run, and adds value to the company from the perspective of seeking funding from potential investors. An investor coming on board in your company will also insist that this be implemented.
6. Non-compete and confidentiality: Co-founders in a company should be bound by express confidentiality terms in the co-founder agreement, restricting them from divulging any confidential information critical to the business (such as proposed products, business plans and marketing strategies) to third parties. Linked to this could be a non-compete provision, restricting a co-founder from competing with the company while he is a shareholder.
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These terms, when clearly and adequately captured in a binding agreement between the co-founders should provide invaluable structure and guidance to a young company, allowing the people behind the wheel the time and space to concentrate their efforts on building a strong business, in a positive environment, without having to worry about disagreements resulting from ambiguity, and being apprehensive of one another.
Shivpriya Nanda - The author is a Partner with JSA, Advocates and Solicitors. The views expressed here are her own.
Arnav Joshi, associate with JSA, Advocates and Solicitors, contributed to this article.
